Hedging with Derivatives

Why this matters

Most of the trading in derivatives that the earlier lessons described has an economic purpose that's easy to lose sight of. Futures markets exist so that producers and users of commodities can hedge, limiting the risk of losing money as prices change.¹ Hedging is the use of derivatives that the rest of the economy depends on, and it's also the use most easily misunderstood, because a hedge that works perfectly looks, on its own, like a losing trade. This lesson works through what a hedge does, what it costs, and what it can't do.

What a hedge is

Hedging means taking a position that gains when something you already have loses. The farmer growing wheat is exposed to a fall in its price. Selling wheat futures creates a position that gains if the price falls. Together, the crop and the futures are worth roughly the same whatever happens to wheat.

The test of a hedge is that there's something being hedged. A farmer with a crop who sells futures has reduced their risk. Someone with no crop who sells the same futures has created a risk. The trade is identical. What it means depends entirely on what else the person holds.

A farmer locks in a price

At planting, December wheat futures trade at $6.00 a bushel. The farmer expects to harvest 40,000 bushels and knows that wheat in their area usually sells for about 30 cents less than the futures price. They sell eight contracts of 5,000 bushels at $6.00, aiming for about $5.70 locally. At harvest they buy the futures back and sell the wheat at the local price.

At harvest	Futures price	Local price	Gain or loss on futures	Crop sold for	Total, per bushel
Prices fall	$5.00	$4.70	+$40,000	$188,000	$5.70
Prices rise	$7.00	$6.70	−$40,000	$268,000	$5.70
Prices fall, local price weaker than usual	$5.00	$4.85	+$40,000	$194,000	$5.85
Prices rise, local price weaker than usual	$7.00	$6.55	−$40,000	$262,000	$5.55

In the first two rows, the hedge does exactly its job: $5.70 a bushel either way. In the third and fourth, the gap between the local price and the futures price changed, and the result moved with it.

The farmer doesn't deliver on the futures. As the CFTC's own example of a Kansas farmer explains, delivering would mean shipping the grain to one of the contract's delivery points, which can cost more than it's worth, so the farmer buys the contracts back and sells the wheat locally.¹ The futures provide the price protection. The local market provides the sale.

Basis risk

The difference between the local cash price and the futures price is called the basis. A hedge fixes the futures price, not the basis. If the basis behaves as expected, the hedge locks in the expected price. If it moves, as in the last two rows, the hedger bears the change. This basis risk is what's left after a hedge, and it can't be removed with the same contract. It's the price of using a standardized contract, with one grade and one set of delivery points, to hedge a crop that may not match either.¹

The cost of the certainty

In the second row, wheat rose to $7.00 and the hedged farmer earned $5.70 instead of $6.70. That's $40,000 that an unhedged neighbour made and they didn't. A hedge that worked looks like a loss on the futures account. Judged by the futures line alone, a farmer who hedged every year would appear to lose money in every rising year. Judged by the business, they removed the year that would have put them out of it.

The rest of this lesson is for members

Still to come in this lesson: Hedging a share portfolio, Futures or options?, What a hedge leaves behind, Hedging for individual investors, the key takeaways, and 2 quiz questions with explanations.

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